Abstract

Knowledge companies who generate their revenue from leveraging the talents and contacts of professionals are confronted with two dilemmas – acquiring institutional funding without hard collateral and managing these revenue-generating talents. These companies appear to have understated balance sheets. Their value, however, can be highly appreciated as is illustrated by the stock prices. This presents a problem when acquiring institutional funding since hard collateral is scarce. Another dilemma becomes how to manage these talents and systems that generate revenue. It would appear, therefore, that both external and internal sources have a need to measure, manage, and grow these assets. However, the quandary still exists, "How does a company identify and measure assets they cannot see?" This paper presents methods currently in use and experiments by applying five of these measurements to a single company over a period of eleven years. The purpose of this exercise is to note any similarities to financial measures and determine the predictability of performance based on these indicators.

Intellectual Capital in Valuing Intangible Assets

Review of the literature shows a shift in employment opportunities from task workers to knowledge workers. During the last ten years, several attempts have tried to measure the value of knowledge work.

Literature Review
The development of technical and information technology has revolutionized the world in both private and public aspects of people’s lives . The effect of these advancements is represented by the proportion of people in various labor categories reported in a U.S. National Bureau of Standards table, developed by Dennis Swyt . Refer to Table 1.

TABLE 1. LABOR CATEGORIES 1900 – 2000

Stephen R. Barley, professor of industrial engineering and industrial management at Stanford University, has calculated certain projections. He believes that by the turn of the century those who work chiefly with information (in sales, managerial and administrative, professional and technical jobs) will be 59% of the workforce. Compared to the 17% in 1900 .

Accounting and measurement practices have developed to support a system, which has been labor and capital intensive. The gradual shift in labor categories calls into question the effectiveness of these measures in an information-intense environment. Deeply embedded is this system is the view that what matters is the efficiency with which capital is employed. However, in many companies, the costs of information have long ago surpassed the costs of equity capital. In a study performed on 2,959 US corporations, Paul Strassmann determined that only 9.4% of these companies are capital-intensive, with the remaining 90.6% being information-intensive. It may be concluded, therefore, that managers have a much greater stake in managing information processes .

The stock market responds to dramatic changes within companies other than capital transactions. A case in point is Saatchi & Saatchi, an advertising agency whose Board of Directors saw fit to dismiss the founder, Maurice Saatchi. With him, several other executives left the company, with several major clients following, including Mars (the candy-maker) and British Airways. On the company’s balance sheet, the dismissal was a non-event; however, the stock fell from 8-⁵/₈ to 4. What investors and analysts at large recognized was what the company’s Board failed to recognize -- the value of the company rested with Maurice and his cohorts .

The lack of recognition displayed in the previous example is far from an isolated event. The problem is that much of the intangible edge or intelligence of companies is unexpressed, tacit knowledge. This tacit knowledge represents untapped reserves as well as that which has been formalized. Thomas Stewart defined intellectual capital as, "Intellectual material that has been formalized, captured, and leveraged to produce a higher-valued asset" .

Intelligence becomes an asset when some useful order is created out of free-floating brainpower. That is, when it is given coherent form (a mailing list, a database, an agenda for a meeting, a description of a process); when it is captured in a way that allows it to be described, shared, and exploited; and when it can be deployed to do something that could not be done if it remained scattered around like so many coins in a gutter. Intellectual capital is packaged useful knowledge.

In this quotation, Thomas Stewart is stating that tacit knowledge must be made explicit so that it can be formalized, captured and leveraged. The process of making knowledge explicit encourages the new knowledge to soak in and become tacit .

Advantages: Why is a knowledge perspective useful? Karl Sweiby answers this question. "Because knowledge is the ultimate wellspring of unlimited resources, and it is crucial for us to understand what knowledge is and what it is not." As knowledge grows in importance as a leveraging tool, the criterion for success of an organization becomes how quickly and effectively an organization learns. According to M. Darling, executive vice-president of human resources for Canadian Imperial Bank of Commerce (CIBC), the rate of learning must equal or exceed the pace of change in the external environment, simply put, keeping one step ahead. CIBC expresses four key elements to organizational learning: 1. Individual learning (individual must remain responsible for his learning needs), 2. Team learning (teams are expected to find ways of ensuring that individual knowledge and ideas are known and shared), 3. Organization learning (establishing learning networks) and 4Customer learning (understanding customer needs, their industry, strategy and agenda) . These four elements interrelate to foster a learning environment.

Leif Edvinsson of the Swedish insurer Skandia, summarizes the view which has made Skandia a leader in the emerging field of intellectual capital. "A company grows, because it has hidden values. To keep growing you must surface them, care for them, and transfer them through the business . . . If managers can measure it, they will value it."

Edvinsson goes on to describe the relationship between traditional capital assets and intellectual assets as the structure of an iceberg. Above the water are the capital assets, visible and measurable. Below the water, however, remains unseen something vastly larger, whose importance everyone knows, but whose shape and size is known by none. He calculates that the ratio between the two is between five-to-one and sixteen-to-one in most organizations . The variability may be attributed to the amount of capital investment required within that industry.

Another reason to recognize and manage these assets is, as previously mentioned, the stock market recognizes the value creating abilities of one corporation over another with its value fluctuations. It is measured, however, only when a merger or purchase takes place, and the excess of purchase price over book value is recorded as goodwill. It follows that the excess of stock value over net book value is intellectual capital. If the market recognizes this value, it would be prudent for managers to monitor this as well.

Finally, Strassman suggests through his studies that indicators of intellectual capital may be predictive by nature. Evidence shows that AT&T, Xerox, IBM and GM started a decline in certain performance indices several years ahead of financial decline . The Productivity Index, which measures the return on investment in managerial resources (details may be found in Appendix C), calculated for these companies indicated a decline in years before their financial downturn. This decline could be explained in two ways: 1) Over-investment in resources, and 2) decrease in productive output from existing resources.

Barriers: Research indicates that barriers to measuring and managing intellectual capital come in two forms. They are reasons not to calculate and reasons not to report. Johnson and Kleiner suggest that the reluctance to calculate is due to difficulty in arriving at a way of measurement and also assemble the data in a format useful for management decision-making . Sveiby maintains, however, that the problem is not how to design the indicators, but how to interpret them .

Sveiby proposes three reasons why companies do not report these measurements. The first is that it seems pointless; that management is not aware of how they can be used to monitor operations. The second is the fear that such indicators might give too much away. Lastly, no rigorous theoretical model for this type of report exits .

Financial Measurements: Traditional measures have been used in accounting for decades and are common to all types of companies. For this reason, they have been used to compare investments between and within companies. They are based, however, on financial performance.

Return on Invested Capital (ROI) is one of the main bottom-line criterions of efficiency popular in financial circles. It measures the profit generated by the capital invested in a company and is used by both creditors and owners. It is also used on a project basis to discriminate in capital spending decisions. Return on Equity (ROE) is the return after tax, in the form of dividends, on stockholders’ investment. Earnings per Share (EPS) is another common measurement easily calculated and also closely watched by shareholders. Timing of transactions and judgments of how to treat certain items can have great influence on the earnings numbers used in the above calculators. Caution should be used, therefore, when interpreting their results.

Measures of Intangibles: A company traditionally invests its capital in two forms -- tangible assets (equipment, buildings, etc.) and intangibles (systems, software, training programs, R & D., etc.). When the decision is made, the company is expecting a return on that investment over time. Treatment of the intangibles, however, requires that the cost be ignored on the Balance Sheet as an investment. Any benefits accrued from these intangible investments increase the ability of the company to perform and increase in value. However, this value is hidden due to reporting requirements. Sveiby outlines a system of intangible measurements in his book, The New Organizational Wealth .

Sveiby divides intangibles into three areas -- employee competence, internal structure, and external structure. Employee competence involves the tacit knowledge, talents, and accumulated experience attained through company investment, education, and on-the-job experiences. It may be argued that these are owned only by the employee and goes home with him at 5:00 and leaves the company with him upon termination of service. Employee’s efforts are aimed in two directions -- external towards customers and internal toward maintaining the organization. Systems, patents, copyrights, models, administrative systems comprise the internal structure. Organizational culture and norms are also part of this structure. External structure includes relationships with customers and suppliers. This will include company image, brand names, and product recognition . Refer to Table 2 for category explanations.

TABLE 2. INTELLECTUAL CAPITAL CATEGORIES

Performance measures designed to capture the elements contributing to these categories describe the relationships between customers, employee knowledge, and structural capital. These three interrelate within the system to produce a product or service satisfying to the customer, also resulting in providing a desired profit for stakeholders. The issue, therefore, is not to measure only financial capital or only intellectual capital, but to develop a balanced system of measurements that will end up creating financial success .

Measures also communicate emphasis. They illustrate where the emphasis has been placed in the past and help in determining where it should be to achieve the company’s goals. Employees and managers both pay attention to areas that are measured. It stands to reason, therefore, that management can and should use measurements as a tool for communicating priorities .

It is important to keep the end-user in mind when formulating appropriate measurements. External users, such as stockholders, customers, and creditors, require accurate information in order to assess the quality of management and determine whether the company will be a reliable supplier or creditor. Internal users require measures with which to measure operations and progress on a regular basis. These two divergent sets of users require different knowledge to achieve their goal .

Once developed, the question becomes whether levels or trends are appropriate. In today’s dynamic environment, levels are difficult to maintain and create difficulties when comparing across divisions or companies. Trends tend to present the most valuable, flexible presentation.

Measurement Selection: When developing a measurement system, considerations should be made for the following four factors when determining what type of system to employ:

1. The degree of human capital-intensity in the organization
2. The organization’s size and structure
3. The firm’s existing human resource capabilities
4. The availability of human resource data .

Edvinsson emphasizes that a company should only measure what is strategically important for growth – the things that will guide the company into the future. "The key" he says, "is linking human capital to structural capital to reach a higher productivity level". The choice of indicators depends on the company’s strategy.

Thomas Stewart sums up the process in three principles:

1. Keep it simple. Having too many measures can blur focus and lesson their importance to users.
2. Measure what is strategically important. Having few measures increases the criticality of selecting measures, which drive toward successful implementation of the company’s strategy.
3. Measure activities that produce intellectual wealth. Identify areas whose leverage will increase the value of the product or service performed .

HR Magazine offered nine attributes of performance indicators as shown in Table 3.

TABLE 3. KEY ATTRIBUTES OF A PERFORMANCE INCICATORS

The measurement of intellectual capital is one important measure, but it is only meaningful in its relationship to other measures.

Efficiency vs. Effectiveness: Often construed as having the same meaning, efficiency and effectiveness measure two very different aspects. Efficiency measures how well an organization is using its capacity. It is calculated only on input variables and, therefore, has a cost focus. An example would be the billable hours of a legal firm. It measures capacity usage and can be a good indicator of short-term profits. However, it does not give any indication of what was done during that time.

Effectiveness measures show how well the organization is satisfying customers’ needs. It is calculated with both input and outcome variables. Because it must employ a measurement source from outside the organization (customer satisfaction polls), it is difficult to measure. Though customer perception is difficult to acquire, it is good to think in these terms, since the perceived value from the customer is the mainstay of future earnings.

Value-Added
Value-added is a common term used in knowledge literature to recognize the value that employees create after deducting all purchases from outside sources. Otherwise stated, products and services are produced by taking inputs from outside the organization and "adding value" to them through applying processes and expertise. The net of income and these outside costs gives the value contributed by the structures and systems within the organization.

The Balanced Scorecard, developed by Kaplan and Norton , is an approach to designing measurements which ensures that no one area receives too much focus at the neglect of another. It links four perspectives: financial, customer, internal business process, and learning and growth. A modified version used by Skandia Corporation and titled the Business Navigator includes the three elements of intellectual capital presented by Sveiby: Human Competence = Human Focus; Internal Structure = Process Focus; and External Structure = Customer Focus. Since the advent of the Business Navigator in Skandia’s reporting, management discussions of growth opportunities and investments have broadened to include products, technology, and customer and employee capabilities.

The balanced scorecard complements traditional financial measures with non-financial measures. Using this approach and grouping measures according to the direction and focus they indicate allows management to ensure a balanced consideration in decision-making.

Internal Assets Monitor. Sveiby considers growth, efficiency, and stability as the three critical areas when measuring intangibles. One or two measures should be included in each box of the matrix. Simplicity is important – too many measures dilute their effectiveness. Below is a table illustrating the matrix to which is added various measures for illustration purposes .

TABLE 4. INTERNAL ASSETS MONITOR

Other measures have been added to this list as well by authors other than Sveiby. Several of their measures attempt to quantify intangible assets as a whole. Descriptions of these and additional measures may be found in Appendix C.

Application
To assist in visualizing these measures, the author selected a company, Rubbermaid, Inc., with which she is familiar. The intention is to calculate as many of the measurements as possible from information obtained in annual reports. The period covered is 1985 through 1996. This eleven year period should be long enough to establish trends and easily accessible through annual reports. The next step is to overlay the resulting trends onto traditional financial measures to determine if any could be considered leading indicators or whether they appear to correlate.

Results: Measures are divided into four groups: Overall, Human Competence, Internal Structure and External Structure. Due to the internal nature of some of the required components, no measures were calculated for Human Competence. Appendices A and B contain charts illustrating trends of these measures. It is easily noted reviewing Appendix A that a spike in 1995 exists. This is due to realignment costs of $158mm that were expended during that year. Therefore, any measures based on earnings reflect this spike. Appendix B adjusts earnings for this extraordinary expense and obtains results that are more appropriate. The discussion that follows refers to Appendix B.

Overall Measures. Common financial measures are illustrated in Chart 1 in Appendix B. They include Earnings per Share, Return on Equity and Return on Assets. Their trends are similar. ROE and ROA remain in the same band, declining in 1996. EPS shows a more irregular pattern, spiking in 1990 and again in 1994. Due to the similarity in trend, ROE was selected to represent financial performance in the rest of the charts in order to simplify presentation.

Calculated Intangible Value (CIV) compares the average ROA for a company versus that for the industry, obtained using information from the Robert Morris Associates’ Annual Statement Studies. The excess return is adjusted for tax and cost of capital, resulting in the value of intangible assets. It describes how well Rubbermaid uses their quantity of tangible assets over that of the industry. Charts # 4 and 6 compare ROE to Calculated Intangible Value (CIV). Chart #4 uses the Intangible Dollars indexed by $100mm increments and measures a steady increase in level of intangibles with a drop in 1996. This is calculated using a three year average of certain variables, resulting in insufficient data to calculate 1985 and 1986. Detailed description may be found in Appendix C.

Chart #6 uses the same CIV dollars divided by tangible dollars to yield a ratio of intangibles to tangibles. Intangible assets are 1.6 times tangibles in 1987, gradually increasing to 2.5 times in 1994, sharply dropping to1.4 times by 1996. Whereas ROE recovers in 1996, this is tied to earnings growth. The intangible ratio is showing a continuing decline in leverage of fixed assets.

Internal Structure: Charts #3 and #5 measure internal structure. Chart #3 uses Working Capital Turns, which is the difference between current assets and current liabilities divided into net sales. The higher the turns, the less capital is tied up in inventories and receivables. It is, therefore, a good indicator of process efficiency. It shows dramatic improvement in 1995 and 1996. Chart #5 uses an Information Productivity Index (IP). This is the Value of Management divided by the Costs of Management. Chart #5 shows a downward turn beginning in 1993. A low index indicates excessive administrative costs to support the value added by management.

Though both of these charts are measures of internal structure, they provide totally different outlooks for the company. Working Capital Turns is based on balance sheet items and sales, whereas IP has an earnings variable attached. This illustrates the volatility of using measures tied to earnings. This variability is due to discretionary policy applications and transaction timing. The Working Capital Turns, in this instance, is the more reliable indicator.

External Structure: Chart #2 is an overall measure of value perceived by the stock market. It is the market value, obtained by multiplying stock price by the number of shares outstanding, and divided by book value. The spike in 1991 precedes a change in Chairman of the Board, with a very high profile chairperson leaving the company. The immediate decline reflects the perception of that intangible human resource. The trend shows a high in 1985 of eight. At this peak, the stock market valued the company at eight times its book value, rising and falling to a low in 1996 of 3.4 times.

Conclusion
Similar trends resulted in the five intangible measures. This is due to the high level of numbers reported in annual reports. There is no opportunity to screen for content. None of the trends was predictive or usable as a leading indicator. This is because of the historical nature of the numbers. Measures accumulated from other sources internal and external would broaden the scope examined. All three categories would be better represented with a wider range of measures, as indicated in the Intangible Assets Monitor. To accomplish this, however, requires access to information on employees and customers as well as process measures. Predictive indicators might be developed using these factors. It is significant that three of the five measures are insensitive to changes in earnings. Comparing both Appendices reveals that charts 2,3, and 6 show no change when earnings increased to exclude large realignment costs. This reaffirms the necessity of having a variety of well-chosen measures.